FX currency swaps

[wrongsaidfred]

Hi David,

I know that you said the testability of this topic is low because of all of the calculations, but if the term structures were not flat how in the world would we do this problem? If this is beyond the scope of what we need to know, that will suffice for an answer.

Thanks,
Mike

 

[David Harper CFA FRM]

Hi Mike,

I do think testability of even flat term structure is low due to tediousness. Under the approach where we value the currency swap as two bonds (e.g., long yen + short US dollar), it's almost the same procedure. If you look at the second tab of http://www.bionicturtle.com/how-to/spreadsheet/3.c.1-swaps/ note ,that rows 18 and 19 "implement" flat interest rate structure by merely copying the two interest rate inputs (e.g., 9% US rate, 4% Japanese rate. I reproduced Hull's example 7.4 exactly). To model a non-flat rate structure, you could just vary those inputs on rows 18 and 19. The thing is, it is just the valuation of two bonds, only that the "second bond" is denominated in Yen, then it's price (PV) is converted at the FX rate. So the procedure is the same as valuing a bond under flat zero (spot) rates (e.g., discount all cash flows at the same 3.0%) compared to valuing a bond under non flat (e.g., discount first coupon at 2.5%, discount next coupon at 3.0% ... still zero/spot rates but increasing/decreasing).

Pulling that all together in a currency swap won't be tested (can't be, not enough time) but IMO the currency swap valuation is more instructive in the way it combines building blocks (swap = 2 bonds; discounting) which themselves can be tested.

I hope that helps, David

 

[wrongsaidfred]

Thank you for the explanation.

Mike